Tactical Changes - Tale of Two Outcomes

In our quarterly commentary, we carried the theme that we are at a crossroads. While we still feel that's true, we feel that both roads lead to disappointment for holders of long-dated risk assets.

I don't mean to make this overly simplistic, but I'm going to try anyway. Here is the investment decision of our time, and investors (and their, ahem, advisors) need to take sides:

Either inflation will rise in the near term or it will not.

As we have written, the Fed is desperately trying to get prices moving up again. Part of its mandate is price stability. What that really means in a paper-money world is a controlled and predictable slow rise of prices. Say, 2.5% to 3.5% per year. The Fed is deathly afraid of deflation. Money supply has grown barely 5.5% in the past year and the Fed would probably prefer to see it grow twice that fast. What little money growth we're getting seems to be pouring into financial assets (and gold) rather than into business expansions and paychecks.

The argument for high inflation takes the position that the Fed will get what it wants, and probably overshoot the mark. Couple that overshooting with rising borrowing demands and you've got yourself an inflation/interest rate/falling dollar scenario that scares the bejeezus out of the doom-and-gloom crowd. Global collapse and all that.

On the other hand...

The Fed could fail. Compelling arguments can be made that without a surge in consumer demand, you just can't get a wage-price spiral rolling. The Fed reports that we're running our economy on 70% of its productive capacity. The official unemployment number is above 10% and the real, actual unemployment number is probably north of 15%. At no time in our history have low capacity utilization and high unemployment numbers paired up and produced spikes of inflation. For reference, capacity utilization was above 83% when inflation spiked in 1978-1980. It takes more than money expansion to produce inflation in the near-term -- it also requires that more money is chasing less output capacity.

There are smart, experienced and successful investment celebrities both sides of this bet-of-a-lifetime. We're not here to make big bets. The difference between most of those pundits, bloggers and analysts is that they either (1) don't invest other people's money for a living; or (2) only invest a small subset of other people's money. If the latter, their job is to be aggressive and be right. If they are neither, they get fired and the client has only lost a few dollars.

Our job, on the other hand, is to preserve the entirety of our clients' life savings. In over 90% of our client relationships, we oversee the entire investment portfolio. We therefore make more measured bets and always err on the conservative side of split decisions. We are tactical allocation investors. The classic model of tactical investing means that, absent a compelling reason to move into or out of an asset class, we stay neutrally invested in a vanilla mix of stocks and bonds. Say, 60% stocks and 40% bonds, with a little foreign thrown in there for flavor.

We are instead going to move away from the classic model. Rather than stay in a vanilla portfolio while waiting for clear signals and opportunities, we are going to move more strongly into a defensive stance. We are in the process of reducing holdings of equities and high-yield bonds and will move those funds into short-term bonds and TIPs, both domestic and foreign. These assets have moved up significantly over the past 9 months. We have profited nicely and it's time to take some of those profits.

Then, we will wait. When there are cracks in the prices of assets that we like for the long-term, we will buy a little and then wait some more. When we look at the choice between "inflation soon" and "inflation later" we see little upside for stocks over the next few years. This is particularly true since we believe that stocks are already trading above their long-term fair value.

So, while the debate rages between a "V" (straight up), a "W" (double-dip) or an "L" (extended doldrums), we will sit quietly by and wait for opportunities.